Risk appetite weakens due to concerns regarding the economic impact of the coronavirus
In a context of extreme equity positioning following sizeable gains since mid-December, as well as elevated valuations with the MSCI Developed Markets Index P/E at 17.3x (22% above its 15-year average), risk appetite faded sharply in the past 3 trading days. Investor sentiment was hurt due to increasing uncertainty about the impact of the coronavirus and the rising risk that the progressive candidate Bernie Sanders may win in the Iowa Democratic Presidential Caucus (February 3rd).
Indeed, global equities fell by 1% in the past week and euro area indices were down by more than 2% on Monday. At the same time, US 10-Year Treasury yields cumulatively declined by 21 bp to 1.61% on Monday (the lowest since October). Moreover, Speculative Grade corporate bond spreads widened on both sides of the Atlantic by 15-30 bps on a weekly basis, albeit from very low levels.
Regarding monetary policy, the ECB kept interest rates unchanged (MRO: 0%, DFR:-0.5%), as expected. The bias to ease interest rates was maintained until robust convergence to the inflation objective is achieved. The QE will continue at a monthly pace of €20bn per month of asset purchases for as long as necessary.
There were some minor positive changes to the introductory statement regarding the assessment of (still tilted to the downside) risks to the economic growth outlook, moving from “somewhat less pronounced” three months ago to “less pronounced as some of the uncertainty surrounding international trade is receding”. Note that January’s PMI revealed a stabilization in activity, albeit at very subdued levels, with the composite PMI at 50.9. Regarding the ECB’s view on underlying inflation, it shifted from “a mild increase in line with expectations" to a “moderate increase”, probably reflecting the current positive outcomes of core inflation (1.3% yoy as of December, the highest rate since April). Note that January’s flash estimate for CPI (January 31st) will be monitored for a better assessment of whether the recent acceleration in core prices is sustained.
The ECB meeting also began its monetary policy strategy review, which is expected to be concluded by end-year. The review will include: i) a detailed analysis of inflation and its subdued performance in recent years, as well as the quantitative formulation of price stability (a symmetrical numerical target of 2% instead of “below, but close to 2%” or a tolerance bank of inflation around 2%); ii) the monetary policy toolkit (interest rates including the potential side effects of low/negative rates, forward guidance, asset purchases, and yield-curve control); iii) It will examine how the economic and monetary analyses through which the ECB assesses the risks to inflation should be updated; and iv) it will review its communication practices probably including votes (by name) on every rate-setting decision.
The Federal Reserve is likely to remain unchanged on January 29th, with interest rates at 1.5%-1.75%. It is expected to be a broadly uneventful meeting as there are no economic and interest rates forecasts scheduled to be released, while Fed officials have reiterated their intention to keep interest rates at their current levels for the time being as policy is in a “good place”. Investor attention remains on the Fed’s liquidity provision to the financial system through T-bill purchases ($200bn since September), which is expected to continue until May 2020 in order to alleviate funding pressures in the repo markets.